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What is Net Working Capital Ratio?
Net working capital ratio shows how much of a company’s current liability can be met with the company’s current assets. The net working capital ratio is the measure of a company’s capability in meeting the obligations that must be paid within the foreseeable future. Therefore, it shows the liquidity that is available with the company to meet the liabilities.
In other words, the net working capital ratio provides the stakeholders of a business with the idea of the business’s liquidity by showing how effective it is in paying off the current liabilities or the short-term debt using its current assets. The values of the denominator and numerator of net working capital ratio are available on the balance sheet of the company.
Formula −
The formula for calculating net working capital ratio is as follows −
$$\mathrm{\mathrm{Net\:Working\:Capital\:Ratio}\:=\:\frac{\mathrm{Current\: Assets}}{\mathrm{Current\: Liabilities}}}$$
Example −
Suppose a company XYZ has Rs. 1,000 Crore in cash, Rs. 2,000 Crore in accounts receivable, Rs. 2,000 Crore in inventory, Rs. 2,500 Crore in current liabilities. Then −
$$\mathrm{\mathrm{Net\:Working\:Capital\:Ratio}\:=\:\frac{\mathrm{Current\: Assets}}{\mathrm{Current\: Liabilities}}}$$
$$\mathrm{\mathrm{Net\:Working\:Capital\:Ratio}\:=\:\frac{\mathrm{\left ( Cash\:+\:Accounts\: Receivable\:+\:Inventory \right )}}{\mathrm{Current\: Liabilities}}}$$
$$\mathrm{=\:\frac{\mathrm{Rs}\: 1,000 \:\mathrm{Cr} + \mathrm{Rs}\: 2,000 \:\mathrm{Cr} + \mathrm{Rs}\: 2,000 \:\mathrm{Cr}}{\mathrm{Rs}\: 2,500 \:\mathrm{Cr} }\:=\:2.0}$$
This means that XYZ company can meet its current liabilities twice with its base of current assets.
Working Capital vs Working Capital Ratio
Measure of capability to service short-term debt
Sometimes, people subtract current liabilities from current assets in order to gain working capital. It is erroneous. The difference between current assets and current liabilities just shows the gap between them. The net working capital ratio is not about the gap between the two factors. Instead, it is a measure of the capability of a company to service the shorty term debt or current liabilities with its base of current assets. The gap between current assets gives working capital, not the net working capital ratio.
Subtracting Current Liabilities from Current Assets
It is important note that the difference obtained by subtracting current liabilities from current assets gives working capital whereas when the current asset is divided by current liability, it gives net working capital ratio.
Current Assets and Current Liabilities
The assets that have a maturity period of one year are known as current assets, whereas the liabilities that must be paid within a year are known as current liabilities.
For the company's well-being, it must be able to repay the liabilities with the assets without having to resource more financing from the market. If a company needs to borrow funds to meet its current liabilities, its financial condition is weak.
Current assets include cash and cash equivalents, marketable securities, prepaid expenses, inventory, and accounts receivable. Current liabilities include accrued expenses, loans payable, and accounts payable. These items are available on the balance sheet of a company in various forms, usually.
Optimum Net Working Capital
When the net working capital ratio goes below 1, the company will have to raise funds from the market to meet its current obligations. A value less than 1 indicates that the amount of current assets is lower than that of current liabilities. That is why, to be prepared for the short-term liabilities, the company’s net working capital ratios must be above 1. Usually, a net working capital value ranging between 1.5 and 2.0 is considered optimal but it depends on the industry of operation of the company.
Comparison of other financial ratios
Like most other financial ratios, net working capital ratio also cannot justify the exact financial condition of a company alone. For best guesses, one must consider other financial ratios and compare the chosen company’s ratios with other companies’ values in the same industry.
Conclusion
Comparing the values obtained with analysis benchmarks can also be a good way to measure the efficiency of a company vis-a-vis its net working capital ratio.
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